The impact that declining world oil production will have during the coming year, and possibly longer, is now inextricably intertwined with the course of the economic recession that is sweeping the world. During 2008 the world’s stock markets lost some $30 trillion in investor equity. Nearly every major government was forced to begin massive bailouts of financial institutions and many have started to support failing businesses. The end is not in sight.

While many peak oil observers long anticipated that faltering world oil production would lead to much higher oil prices and eventually to an associated economic meltdown, the setbacks of the last year have complicated the situation. While it is clear that worldwide demand for oil has stopped growing and has started to decline in the last six months, it is not yet clear just how fast demand is falling. The sudden drop in oil prices has further complicated the situation by setting off a race between falling prices and slowing economic activity.

Nearly all observers are forecasting that the economic situation will get worse for at least the next six months as foreclosures increase, real estate values continue falling, retail downsizes, and unemployment grows. From there on opinions vary. Some believe that the trillions in financial and business bailouts and massive government stimulus spending will stabilize the US and world economy, eventually leading to economic growth. Others believe that spending so much borrowed money will only exacerbate the current situation and that far worse times are ahead.

Some peak oil pragmatists look at the US airlines and auto industries as the canaries in the recession’s coal mine. Hit last spring with oil prices too high to work with their business model, plus a recession, the airlines blinked. Virtually all announced major schedule cutbacks. The recession has pushed the Detroit Big Three to near bankruptcy. This year will likely determine their future.

2. Price Volatility: Who Knew?

In a case of extreme dissonance, oil and gas prices first rocketed and then crashed in unprecedented fashion during 2008, setting records and trashing forecasts in all camps. Oil: from $90 to $147 to $34? Natural gas prices doubled, then dove. Some coal tripled, then retreated too.

Why the enormous swings? With hindsight, the drivers to the upside seemed to be a mix of the fundamentals and speculation. First and foremost, it was obvious but too often overlooked that flat oil supply and increasing demand is a recipe for a price surge. Then too, stockpiles were well below norms during the spring price run-up. A growing mismatch between marginal supply (e.g., Iran’s heavy oil) and available refining capacity to process that oil didn’t help. Shrinking exports from Russia, Mexico and 13 other leading exporters—down 2.5% from 2006—sent a price signal.

On the investment front, the sinking dollar and hammered equities drove investors towards the full suite of commodities, not just oil. Goldman Sach’s report in early May forecast $150-$200 oil within 6-24 months—one of several analyses that probably stimulated some late-cycle gambling. And any geopolitical moves in the oil patch—violence in Nigeria, nuclear chatter from Iran, explosions on the BTC pipeline in Turkey, etc.—were bullish factors pushing up prices and driving fisherman, farmers and truckers to strike and protest the financial pain.

And then came the crash, a 75% price drop over just 5 months that stunned producers. While the crash handed staggering American consumers what is now a billion-dollar-a-day unscheduled bailout, remember that the oil price run-up—a primary trigger in most of the major recessions since 1973—was a leading-edge factor in our deepening recession.

An almost tragic byproduct of 2008’s violent oil price swings is that it sends confusing signals about our long-term oil supply constraints to decision makers at all levels. For example, low gasoline prices are helping lure some car-buyers back to near-dead SUV showroom floors…

3. Falling Investment = Building the Big Boomerang

During the first half of 2008, spiraling costs in the oil sector led to the periodic announcement, especially from oil exporting countries, that a few production or refinery projects were being delayed, decisions put on hold. It didn’t help that the industry—from fully-booked drilling rigs and tankerage to an over-booked and aging engineering corps—appeared stretched thin. The International Energy Agency sounded warnings of under-investment by the oil industry.

Then came the crash. During the fourth quarter, when demand declined and oil prices dropped to four-year lows that few industry players had anticipated, a daily drumbeat of project delay and cancellation notices flowed from the industry. Among the earliest casualties were the Alberta tar sands processing projects which require massive amounts of capital for every barrel of production capacity; one company even announced a 50-percent cutback at their existing tar sands operations because $40 oil does not cover current costs to excavate and separate bitumen from sand. Additionally, some proposed deepwater projects don’t work with oil prices under $60 a barrel.
Tighter credit is also taking its toll. While major international oil companies may have financing in place or can self-finance projects, smaller companies delayed or cancelled plans due to lack of liquidity. That same liquidity issue also battered prospects for front-loaded renewable energy financing as well as funding for extremely expensive “clean-coal” and coal-to-liquids projects. While national oil companies made massive profits through September, the October-December price drop hammered those producing countries where the bulk of their oil revenues are diverted to run government programs; they will soon be in no position to invest in new production developments.

While worldwide demand for oil is falling, it isn’t dropping as fast as investment in new production. Bottom line: the slowdown in new oil production projects will obviously have a major effect on future oil production rates. It may be several years before cancelled or delayed projects fully impact the world’s capacity to replace declining production, let alone grow that production again. If the economy should stabilize during the next year or two, and demand for oil snaps back, expect prices to boomerang back above $150. Investment uncertainty guarantees higher price volatility just a few years out.

4. The IEA Changes its Stance (will U.S. EIA, CERA and Exxon-Mobil follow?)

During July 2007, the International Energy Agency announced its intention to conduct a bottom-up study of worldwide oil field production in order to better inform their OECD member about prospects for future supply growth. They more than hinted at accelerating supply and price troubles to come. That warning was echoed again in July 2008 when the IEA cut its supply forecast for the next five years. Realism seemed to be settling in at the Paris-based energy office.

On November 12th, the IEA released its World Energy Outlook 2008, a forecast that broke with their past tradition of projecting demand and then assuming supply would rise up to meet it. The report was a curious mix of unreality (liquid fuel supplies can grow steadily between now and 2030) and unprecedented warning of an energy crisis to come. Breakthrough findings included:

Half the world’s oil comes from the 110 largest fields; many of those are post-peak and aging.

The natural decline rates [all drilling stops] for fields past their peak is 9% and rising.

Observed decline rates [drilling/maintenance continues] for fields past their peak production rate is 6.7% today, rising to 8.6% by 2030.

Much of the media coverage of the WEO 2008 focused on the stated need to discover and/or develop 64 million barrels a day—“6 new Saudi Arabias”—of new production by 2030. Digging deeper into the IEA’s detailed assumptions uncovered some trends which IEA forecasts that raise major questions:

Will the US will only lose 400,000 bpd in production over the next 22 years, compared to 800,000 bpd over the last seven years?

Will Mexico only lose 500,000 bpd from its 3.5 million bpd in 2007, despite production at their mainstay producing field (Cantarell) being in a tailspin?

By 2030, will China only lose 200,000 bpd, despite China’s admission that their production should peak by 2012; etc.?

Yet despite these and other weaknesses, the report’s “unsustainable” position statement was one of many that broke new ground.
Finally, in an important post-script to their WEO 2008, Dr. Fatih Birol, the IEA’s chief economist, was interviewed by the Guardian newspaper during mid-December. When asked what the phrase oil production “leveling off towards the end of the projection period” meant, Birol gave the interviewer the date 2020. Yes, peak oil by 2020… While that’s still way too optimistic a view for many realists and pragmatists, that statement represents a major turnaround for an agency that has previously supported the “no peak in sight” mantra.

5. The Campaign and the Elections

Until the price crash which started in July, it looked as if this year’s US federal elections were going to be about gasoline prices and little else. As prices rose to the $4 - $5 level, politicians running for office became so nervous that proposals to counter high gasoline prices were flying all over the landscape. Some wanted to cut gas taxes; many wanted to scrap environmental restrictions on drilling; and some wanted to ban speculation. That most of these suggestions were of dubious value or would take many years to implement was of little import. It was the appearance of concern that counted.

As gasoline prices fell during the summer and fall, however, and the need for immediate action diminished, the wilder proposals disappeared, but a fundamental disagreement of whether more domestic and offshore drilling would solve the problem continued to November. Yet the hard facts—that offshore drilling won’t contribute substantively to supply for a decade, that peak flow from the “new offshore” would perhaps equal 1+ percent of current consumption, etc.—were generally missing from the dialogue.

The election of Barak Obama to the presidency clearly will bring about a major change in the US government’s approach to global warming and energy policies. As yet, there has been little discussion of oil depletion by the new administration outside of ritualistic and poorly-informed pronouncements about energy independence. So far statements and appointments made by President-elect Obama show that he will clearly place a major emphasis on reducing fossil fuel emissions, promoting renewable sources and efficient use of energy, goals which are compatible with preparations for peak oil.

6. OPEC Cuts Production

Last spring, OPEC, and most particularly the Saudis, came under heavy pressure to increase production as oil prices were increasing so rapidly it seemed as if industrial civilization was about to be pushed over the edge. President Bush visited the Saudis and Riyadh even put on a special producer/consumer gathering in June to announce that the Kingdom was increasing production from newly completed wells to help with the crisis.

Within weeks, however, the landscape shifted and oil prices began the unprecedented plunge that brought the average prices that OPEC received for its oil from an all time high of $147 a barrel in early July to $35 last week. As prices fell through $100 in mid-September and then $60 in mid-October, OPEC became increasingly nervous. Not only was oil falling below the cost of exploring and drilling for new production, the producers’ national budgets which are heavily dependent on oil revenue were being devastated.

In a series of meetings beginning in September, OPEC announced production cuts that now total on the order of 4 million b/d. As ignoring such cuts is a long tradition within OPEC, the oil markets were rightly skeptical that the cuts would actually be made. Much to OPEC’s chagrin, oil prices continued to fall as each production cut was hinted at or announced. In the last week, however, as more details of the cuts have been announced and OPEC’s customers have started reporting that they expect to receive less oil in coming weeks, the market’s skepticism has been slackening.

7. The Large Exporters: from Boom to Busted

As oil prices rose steeply in recent years, OPEC and the other major oil exporters benefited greatly. In 2001 the average value of OPEC oil exports for the year was $23 a barrel and in 2008 it was on the order of $95. This four-fold increase in oil revenues had varying effects. Some countries such as Norway and the smaller Gulf States quietly stashed the money away in sovereign wealth funds for the benefit of their grandchildren. A few, such as Russia, Iran, and Venezuela, became belligerent, using the new-found wealth to promote their leaders’ ideological goals and great power aspirations. Resource nationalism abounded as governments felt they could now do without foreign investment and technical expertise.

In the last six months however, many of these aspirations have been brought up short by the collapse in oil prices. Hardest hit have been those exporters with large populations to support such as Iran (65 million), Venezuela (26 million), Russia (140 million), Mexico (110 million) and Nigeria (146 million). Adding insult to injury, production in all five of these countries is either declining or flat while domestic consumption increases; that means declining net exports—another hit to the bottom line for the exporters, plus a looming pothole for the world’s oil importers.

Although 2008 was a banner year for exporters, as prices were above $100 a barrel until September, after the price crash their cash flow is becoming a huge problem. Development projects are being cancelled, stock markets are crashing, budgets are being reworked and political unrest may be in the wind as countries like Iran consider eliminating large gasoline price subsidies. Even some of the more belligerent geopolitical posturing seems to be moderating as governments turn to more pressing domestic issues.
Unless prices rebound soon, major exporters with little other revenue will be hurting.

8. Shale Gas: Game Changer or Rope-a-Dope? [or “a mixed blessing”]

After essentially no net increase from 1994-2006, U.S. natural gas production rose 4% during 2007 and will have increased between 6% and 7% in 2008, despite shut-ins for Gustav and Ike. The biggest single reason for this is increased flows from shale gas. In a world without deep recessions, this success might have continued the current run for several more years. Indeed, shale gas will still play a key role in US natural gas production for decades, but that isn’t unqualified good news.

The industry knew about shale gas for many decades. In fact, the nation’s second-largest producing field today—Texas’ Barnett Shale—was discovered in 1981. But back then, the industry didn’t know how to exploit the resource on a large scale. Application of horizontal drilling in the Barnett Shale changed that. Compared to drilling vertical wells for conventional gas, this unconventional resource requires more drilling, more hydraulic fracturing work—more cost and more energy inputs. The breakeven costs (plus 10%) for most of the shale-gas plays falls between $5 and $6.50 per Mcf of natural gas. During the last five months of 2008, natural gas prices dropped 50% from their July peak; the combination of that price crash plus recession-induced destruction of demand for natural gas forced the gas industry to start idling rigs. Of the 1600 rigs drilling for gas as recently as September, as many as 400 will likely be stacked soon.

There’s a related nasty catch with shale gas: during the first year after a shale-gas well is drilled, upwards of 2/3 of the ultimately recoverable gas flows from the well; that’s a lot faster decline rate than conventional wells experience. So the more reliant we become on shale gas wells, the more susceptible we will become to wider swings in supply. Relying on shale gas is likely to cause much more volatility in prices.

9. Food vs. Fuel Hit Pocketbooks Worldwide

2008 started with a rash of reports by respected organizations about a worrisome if highly predictable phenomenon: increased use of biofuels was helping push up food prices worldwide. Two Purdue University agricultural economists published in late 2007 that two-thirds of food cost increases from 2005-2007 were related to biofuels. During the previous six years, land planted for biofuels increased from 12 to 80 million hectares as subsidies and national policies mandating their use were driving the rush to biofuels. The UN’s food price index, based on export prices for internationally traded foodstuffs, climbed 14 percent in 2006, 37 percent in 2007, and continued apace into 2008. Rapidly rising food prices obviously result in hunger and political instability as more people become desperate in their search for affordable food. During 2008 food riots erupted in Mexico, Italy, Morocco, Pakistan, Yemen, Senegal, Mauritania and elsewhere. Press reports popped up about “how the rich are starving the world by making biofuels—dubbed by some as “a crime against humanity.”

In the US, the ethanol industry and its reported $25 billion in federal handouts started in 1978, picked up enormous momentum after the August 2005 Energy Security Policy Act, and accelerated even faster after Congress passed the Renewable Fuels Standard in December 2007. Now, thanks to one of the most divisive agricultural policies in the US, there are 178 ethanol distilleries in the US that will likely consume over 30% of the US corn crop and produce just under 600,000 b/d of corn ethanol. (Adjusted for energy equivalency, that offsets roughly 400,000 b/d of US oil consumption—around 2% of our daily oil diet—excluding the large net-energy problem that plagues corn ethanol.) Yet after 30 years of R&D, a $0.51/gal tax credit and tariffs on imported biofuels, the industry still can’t compete; large ethanol player VeraSun filed for bankruptcy in late October, and now the industry is asking Congress for bailout dollars.

The year ended with an op-ed from the Investor’s Business Daily in which they made this point: “The heavily subsidized ethanol industry is the latest to seek a federal bailout. If there is any industry that deserves to go bankrupt, it's this one. Time has come to stop putting food in our gas tanks.” In the interests of the food vs. fuel battle, we tend to agree.

10. Global Production Peaks, on the Production Plateau

The EIA reports that since 2005 production of conventional oil has been on a plateau, cycling up and down between 72 and 74 million b/d. In July 2008 production reached a new all-time high of 74.86 million b/d and has been dropping since. As OPEC is currently implementing production cuts totaling 4 million b/d, several major producers such as Mexico and Russia are in decline or do not have much growth potential; and investment in new production is drying up due to economic conditions, the likelihood that the July bump to a new high will stand as the all-time peak of world conventional oil production is increasing.

The IEA reports that “all-liquids” production which includes conventional oil, biofuels, natural gas liquids, and tar sands production, reached 86.5 million b/d in November, but this is subject to revision.

It is ironic that the all-time peak of world oil production seems to be happening in the midst of a global recession of unknown duration. While it is possible that the global economy could rebound in the next few years and markedly increase the demand for oil, it is clear that the industry is no longer able to respond with large increases in production as it did earlier this decade. All things considered, it is inevitable that declining world oil production, which is currently linked to declining demand and OPEC policy, will eventually be governed by production constraints. These constraints, due to a combination of geological factors, lack of adequate investment, geopolitical conflicts, and resource nationalism, make it likely that oil production will never again reach the highs seen in 2008.